Planning for Success in All Phases of Your Business Relationship
By Bill Piercy and Mark L. Zyla
Going into business with a partner can be the best or worst decision an entrepreneur ever makes. Given the stakes, it is a decision worthy of significant deliberation. This article explores effective strategies for the creation, maintenance and termination of those business relationships.
Creating Business Relationships
There can be significant advantages to going into business with a partner, who may bring capital, offer complimentary skills, and share the grunt work as well as the risks of starting a new business. Alternatively, taking on business partners can make a company less nimble in a competitive environment. Partners may not always agree on business decisions and each is generally entitled to his or her pro rata share of profits – regardless who did the work to earn them.
No matter how well you think you know a prospective partner, ask their permission to perform a background and credit check on them, and offer to allow them to do the same to you. This simple, inexpensive step has saved many new business owners from entering into business relationships that are destined to fail.
Consider requesting personal financial statements from a prospective business partner as well. Though this can be a sensitive request, it is important to understand the implications of entering into business partnerships with others when there is a large net worth discrepancy. Many business owners are required to personally guaranty business related leases, lines of credit and the like. If the landlord or bank ever make a claim under the guarantees, you will want to be sure that your partner can cover his share of any such obligation.
At the same time, what may be an all-in investment for one partner could be a minimal investment for another. Commitment to making the business a success might just be commensurate with the significance of the investment when compared to each partners’ balance sheet.
Once comfortable with the prospective partners involved, it is time to discuss and agree upon business issues relating to contributions, compensation, business operations, valuation issues and business strategies. By working through these issues upfront – and agreeing while everyone is agreeable – the partners will decrease the chances of the relationship ending poorly. Negotiating these issues at the outset will offer a glimpse of what it will be like to be in business with your prospective partner.
Common Money Issues
- Will each partner make an initial contribution to start the company? If so, should any portion of that contribution be treated as a loan, or is it all a capital contribution?
- If the company gets into a financial bind down the road, what are the obligations of the partners to put in additional capital? Will the company try to secure a loan or a line of credit, or will each partner have to contribute an equal amount? Is there a cap on how much everyone is required to contribute?
- How will owners be compensated? Will each partner draw a salary, and if times are tough, will that salary be deferred?
Common Operational Issues
- Is a certain partner going to manage day-to-day operations? What are the limits on the authority of that partner when it comes to common decisions?
- How much of a time commitment is expected of each partner?
Legal Issues
- What are the partners’ “duty of loyalty” expectations? In other words, can a partner work for or be involved with a company in the same industry as the partners’ business?
- Are there restrictive covenants you want to impose on the partners?
- If the business is successful, at what point do you want to sell? If it is not profitable, at what point do you pull the plug?
If the business partners agree to proceed with the relationship after discussing the issues described above, all of the understandings of the business partners should be memorialized in a written agreement.
In addition to the points above, the agreement should also handle other important issues, including:
- The occurrence of events that would trigger the end of the relationship, such as death, disability, divorce and the termination of a partner’s employment with the company;
- Minority owner issues, such as the inclusion of drag along rights and tag along rights;
- Transferability of ownership interests (How liquid do the partners want their investments to be?);
- The timing and amount of dividend or distribution payments; and,
- Mechanisms for breaking a deadlock.
Ultimately, regardless of the size or scope of the business being contemplated, it is important to establish expectations. By working through the issues described above with the help of their professional advisors, and memorializing their agreements in a written document, the business partners will have maximized the opportunity for a successful business partnership.
Valuation Issues
Proper planning in structuring the business relationships have important implications as to the value of the entity in the future.
- Valuation Methodologies in Shareholder Agreements/Exits. Does the agreement call for a formula such as a multiple of earnings or does it require the retention of a valuation expert?
- How is the ownership of intellectual property considered? Does the entity retain the rights to any technology, customer relationship and tradenames developed by the shareholders?
- Does the initial capital contribution equal ownership percentage? If not, what is the difference and why? This issue needs to be clearly defined.
- What is the definition of “value” in the shareholder agreement? The definition of “value” provides guidance as to assumptions in the valuation.
- Tax structure of the entity. Is the entity a regular “C” corporation or is it a pass-through entity with the tax liability the responsibility of the owners?
- Integrity of the financial information. Who is responsible for the accounting, and is there an outside party involved as to its assurance?
Maintaining Business Relationships
Like all relationships, some basic maintenance is necessary to keep things working smoothly, if not required.
An important part of this maintenance is a regular review of company records, including bank and credit card statements, accounts receivable and balance sheets. You will also want to periodically review – and update, if necessary – corporate documents to ensure that they still reflect the goals and value of your business.
Day-to-day operational items like leases, vendor contracts and employment agreements should also be reviewed from time-to-time to make sure they don’t need updating based on company growth or some other reason.
It pays to have regularly scheduled meetings of all business partners on a monthly basis, if not more frequently. Communication is the cornerstone of any productive relationship, and a lack of it between business partners can eventually breed distrust. Make sure you have an open and regular dialogue on financial and operational issues so small challenges can be addressed before they become large ones.
These meetings are also a great time to talk about short-and long-term planning, so your company is always functioning as it should. Issues like ownership structure, as well as partner responsibilities, workload and compensation should be openly discussed to make certain everyone is still on the same page. It also gives those that would like to see a change a forum to discuss it with the rest of the partners.
Terminating Business Relationships
All good things must come to an end, and business partnerships are not meant to last forever. Goals change. Markets shift. Partners retire, lose interest or simply decide to pursue other opportunities. It’s important to plan for such contingencies.
When it is time for your business partnership to end, there are many ways to unwind that relationship. Ideally, the separation can occur amicably, and there are many ways to do this.
Three of the most common frameworks are:
- Wind down. You can simply “wind down” and cease operations, sell the company’s assets, pay off creditors and distribute the rest among the partners, pro rata.
- Buy-Sell. One partner may be in a position to buy out the ownership interest of the one that is interested in leaving.
- Sell. The partners can sell the business entirely to a third party.
A well-defined relationship from the beginning – and the documents to back it up – is a good start. Sometimes though, good corporate documents are not enough to keep a partnership breakup amicable. Even business partners who start off with the best of intentions can find themselves at odds with each other due to a variety of circumstances. In these instances, it is important to quickly assess and establish the rights and responsibilities of the respective parties, as well as your own goals for exiting the relationship.
A good first step is to exercise your right to inspect company documents. Most states allow partners, LLC members and shareholders in a corporation to inspect the books and records of a business on reasonable notice. Armed with this information, you can determine your rights, and what duties or obligations your partners may have to you and/or may have violated.
If an analysis of the underlying corporate documents reveals that one or more owners or managers in the business failed to fulfill obligations to the business and/or to other owners, this information can be a powerful tool with which to negotiate an exit from the business by you or your partner. Should a partner refuse to come to the negotiating table, filing a lawsuit will compel his or her participation in the windup of the business relationship. The law recognizes several potential claims aimed at resolving disputes between business partners, including:
- Breach of Contract. A contract is breached when a party that is bound by its provision to perform a duty declines or fails to do so without legal excuse and through no fault of the opposite party.
- Breach of Fiduciary Duty. A fiduciary duty is an obligation to act in the best interest of another party (business partner) and is breached when the partner acts in any manner contrary to the interests of the company or for his own benefit.
- Tortious Deprivation of Corporate Interest. All too often, business ownership interests are not properly documented. While this makes the ownership interest harder to prove, it does not deny its existence. When one partner takes steps to deny another owner the benefits of ownership, they may be liable for tortious deprivation of corporate interest.
- Usurpation of Corporate Opportunity. A corporate opportunity is a business opportunity that a corporation is financially able to undertake, in the same line of business as the company, provides a practical advantage to the partnership and is in an area where the corporation has an interest. It is usurped when current or former officers exploit for their own interest opportunities that came to their attention during their tenure with the corporation. It can also be usurped if a partner engages in a line of business on their own that could have been pursued by the company.
- Tortious Interference with Contractual and/or Prospective Business Relations. A contract or business relationship is tortiously interfered with when a contract or beneficial relationship is unfairly interfered with by an outside contractual relationship, a third party or a breach of contract.
- Declaratory Judgment. A ruling by the court on the legality and impact of anticipated actions or inactions. It is often used for ownership and management rights disputes and disagreements regarding non-competes and non-solicit agreements.
- Judicial Dissolution. If partners become so deadlocked in decisions about the operations and direction of the company that the business can no longer function, the courts can appoint a receiver to marshal and sell the company assets.
While the courtroom is not an ideal place to terminate a business relationship, it has the advantage of being the one compulsory forum in which your adversary’s consent is not required.
The old saying, “an ounce of prevention is worth a pound of cure,” really rings true here, and we recommend you get the legal advice and assistance you need to ensure your business partnership starts on the right foot and is established in a way that will allow you to pursue and reach your long-term personal and financial goals.
About the Authors
Bill Piercy is a shareholder at Berman Fink Van Horn, P.C., an Atlanta-based law firm. He may be reached at (404) 693-8399 or bpiercy@bfvlaw.com.
Mark Zyla CPA/ABV, CFA, ASA is a managing director of Acuitas, Inc., an Atlanta-based business valuation and litigation consultancy firm. He may be reached at (404) 898.1137 or mzyla@acuitasinc.com.
